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The rising popularity of Exchange Traded Funds is neither overly surprising nor inherently difficult to comprehend. Much in the same manner that mutual funds came to flourish, ETFs offer a wide range diversifying products for a cost that usually far undercuts what one could accomplish on their own. As a dividend growth investor, I have become increasingly interested in comparing the rationale of investing in a collection of dividend growth stocks versus allocating capital to a specified ETF.

Specifically, I wanted to compare dividend growth investing to the consumer goods industry. Why this particular sector? I simply made a list of my 50 or so favorite dividend paying companies and found that an overwhelming sampling of these firms fell into this category. As a proxy will use the Select Sector Consumer Staples SPDR (XLP), which includes such well known dividend growth stalwarts as Procter & Gamble (PG), Wal-Mart (WMT), Coca-Cola (KO), PepsiCo (PEP) and Colgate-Palmolive (CL). Let's dive into the comparison within four key areas: Portfolio composition, Yield and Dividend Growth potential, Fees and the Selective nature of each style's holdings.

Portfolio Allocation

You know the math. Or at least if you consider yourself an average investor you know the logic behind the math. In order to have a diversified portfolio you need a minimum of 20 to 30 stocks that aren't directly correlated. The key here is the uncorrelated part. Of course if the market tanks, there's more than enough market risk to ensure that everyone takes the roller coaster ride down. Obviously the magnitude and viciousness of such a fall isn't lock-step, such that some will weather the storm better than others. But the idea remains that a single stock is riskier than 10 stocks which are in turn are riskier 100 holdings. Then again if all of the companies are in the same industry, one hasn't gained much in the way of diversification.

The XLP ETF is comprised of 42 consumer staple companies tracking the consumer staples industry. Of the entire S&P 500 this particular index only captures about 11% of the market. So while the 42 holdings represent the correct number of securities to have for diversification they do not fit the criterion of being independent in such a way as to ensure lower correlations. It would be possible to have a collection of dividend growth stocks with say half or even a fourth of the number of securities and represent a much more diversified picture.

In the real world, one is not limited to the option of selecting a single ETF versus a handful of specified stocks. However, I would argue that many investors are constantly faced with limited capital allocation decisions that usually lead to a momentary, it not lasting, concentration of funds. That is while one is practically well aware that they should be diversified, certain frictional or psychological costs may become apparent. For example, one would be ill-advised to invest in 30 stocks with a starting capital of $1000. The transaction costs would eat your returns alive. Likewise, one may not feel like buying the energy sector simply for the diversification factor if they compute that it happens to be overvalued at the moment that they have additional capital.

With regard to diversification it is true both that one cannot get rid of systematic risk, and that you are not compensated for carrying unsystematic or firm specific risk. The need to carry many baskets with many eggs is evident, but I don't think you have to get there in a single shopping spree. The XLP ETF adds value in that one is purchasing a collection of stocks for a low fee. The individual picking of dividend growth stocks adds value in that one is able to purposely select their favorite companies. Favorite in that you feel earnings will grow, dividend increases will far outpace inflation and the long-term sustainability of the company's moat is well in place. In either case one cannot create diversification in a single bound.

No harm no foul, no points awarded to either side.

Yield & Dividend Growth Potential

The underlying reason that I chose this topic was due to the fact that I happened to glance at XLP's holdings. Here's a look at the top 10 holdings, their individual weighting and dividend characteristics:

Company

Symbol

% Assets

Div Yield

Contribution to Yield

Procter & Gamble

PG

14.08%

3.20%

0.45%

Phillip Morris

PM

11.28%

3.80%

0.43%

Wal-Mart

WMT

7.91%

2.30%

0.18%

Coca-Cola

KO

7.07%

2.95%

0.21%

Kraft

KFT

5.19%

3.10%

0.16%

CVS Caremark

CVS

5.04%

1.50%

0.08%

Altria

MO

4.73%

5.50%

0.26%

Colgate-Palmolive

CL

3.78%

2.50%

0.09%

PepsiCo

PEP

3.77%

3.30%

0.12%

Costco

COST

3.19%

1.10%

0.04%

2.02%

Top 10 % Out

66.04%

Average Yield

2.93%

Current Yield 2.67%

Source

Additionally, there are a variety of other well known dividend growth stocks outside of the Top 10, such as Kimberly-Clark (KMB), Walgreen's (WAG) and Clorox (CLX). If I were hand picking a portfolio, my underlying foundation would look a great deal like the XLP collection. Of course price paid and overall fit are paramount, but in general choosing wonderful companies with oversized moats is usually a reasonable decision.

The issue I have with the Select Sector Consumer Staples SPDR (XLP) is the current yield coming in at just 2.67%. Within dividend growth investing there are practically two distinct camps; one that prefers higher yield and settles for a lower dividend growth and one that settles for a lower initial yield in preference for a higher dividend growth rate. To be sure both strategies are meaningful ways to enhance one's purchasing power. As a result, the decision of one over another is largely personal in that the choice usually balances on one's specified time-frame. I would argue that everyone's time frame is long-term, but then again is long-term 10 years or 50 years? Here's an article that can help find that sweet spot.

The current yield for the XLP is below the common 3% threshold that many income investors have. The 2.67% yield isn't particularly troublesome, but the way in which it is reached does strike me as a bit odd. For example, the Top 10 XLP holdings have an average yield of about 2.93%, with 6 of the 10 being above the average mark. Furthermore, while the top 10 stocks make up about 66% of the portfolio, their contributed 2.02% to the dividend yield represents almost 76% of the total dividend. Thus the other 32 holdings are collectively below average on the dividend front. To me this simply isn't ideal. One buys the XLP for the companies, finds price fluctuations from its largest holdings and yet the dividend yield is dragged down by the smaller weighted firms.

Still, if this lower yield came in the way of higher future dividend growth one might be interested still. For the XLP I found a 5-year dividend growth rate of about 11.7% and a 9-year dividend growth rate close to 10%; although this did include a momentary decline in dividends per share between 2002 and 2004. Still, if these rates can hold up in the future this suggest that one's yield on cost could double in about 7 years. Let's compare this to some of XLP's top holdings:

Average 10-year dividend growth rate

Procter & Gamble - 10.9%
Wal-Mart - 17.8%
Coca-Cola - 10%
Altria - 11.7%
Colgate-Palmolive - 12.4%
PepsiCo - 13%

On a selective basis, it appears one could do slightly better than the XLP in dividend growth by simply choosing their favorite dividend growth stocks. But I don't think one would lose much sleep over 10% dividend growth in the coming decade. I believe the XLP will provide comparable dividend growth albeit without the succinct methodology of a dividend growth portfolio. However, the lower initial yield does appear to be problematic. One could easily build a higher yield portfolio with comparable dividend growth prospects. In this way, the awarded point goes to selecting individual dividend growth stocks.

Let's tally the points before we move on to Part 2. The XLP is comparative to a portfolio of dividend growth stocks in that it holds many of the most formidable names in the dividend game; companies such as Procter & Gamble, Wal-Mart, Coca-Cola and PepsiCo. Although we understand that diversification is important, it can be difficult to do in a single bound. Thus neither buying the XLP, which represents just 11% of the S&P 500 nor selecting say 10 dividend growth stocks will provide diversification. On the current yield and dividend growth scene, the individual selection appears to carry more weight. The starting point is most important, as both have comparable dividend growth rates. The individual portfolio of dividend growth stocks takes the edge. Let's move on to Part 2.

Continue to Part 2 >>

Source: Dividend Growth Stocks Vs. The XLP, Part 1